Chapter 2: How Interest Rates

Are Determined

Financial Markets and Institutions 1

Chapter 2
 Chapter Objectives
Definition of money, three basic functions of
money
The matter of present value
Define the types of credit instruments
The distinguish between the terms interest rate,
yield to maturity
Economic Forces That Affect Interest Rates
Organization of the Federal Reserve System

Financial Markets and Institutions 2

Chapter 2
 Economists' Meaning of Money
Money is anything that is generally accepted
in payment for goods and services and for the
repayment of debts, as a matter of social
custom.
Money is defined more by its function (what
purposes it serves) than by its form (coin,
paper, gold bars, etc.).
Money must be distinguished from both
"wealth" and "income."
Financial Markets and Institutions 3
Chapter 2
 Economists' Meaning of Money
The wealth of an agent at any given point in time
is the current market value of the total collection of
assets currently owned by that agent. (money
holdings, land, equipment)
On the other hand, income is a flow of value
accrued over some specified period of time.
Example: A student works as a teaching
assistant, earning $900 per month, and has a
checking account balance of $400.
He also owns a car - $1100, Books worth $500

Financial Markets and Institutions 4

Chapter 2
 Economists' Meaning of Money
It means he has
Money holdings = $400;
Wealth = Market value of his asset holdings consisting
of (money holdings, car, books)
= ($400 + $1,100 + $500) = $2,000,
Income = $900 per month
Income is a flow variable, it measures an amount of
value accrued over a specified period of time
In contrast, money and wealth are both stock
variables in the sense that they measure an amount
of value at a given point in time

Financial Markets and Institutions 5

Chapter 2
 Functions of Money
Money performs three basic functions in an
economy:
It serves as a unit of account;
A unit in terms of which a single price for every
good and service can be quoted
It serves as a medium of exchange;
An accepted means of payment for trade of
goods and services.
It serves as a store of value.
A repository of purchasing power for future use.
Financial Markets and Institutions 6
Chapter 2
 Interest Rates, Compounding,
and Present Value
In economics, an interest rate is known as
the yield to maturity.
Compounding is the process that gives us
the value of a sum invested over time at a
positive rate of interest.
Present value is the process that tells us
how much an expected future payment is
worth today.

Financial Markets and Institutions 7

Chapter 2
 Compounding
Assume you have $1 which you place in an
account paying 10% annually.
How much will you have in one year, two
years, etc?
An amount of $1 at 10% interest
Year 1 2 3 n
$1.10 $1.21 $1.33 $1(1 + i)n

Formula: FV = PV(1 + i)n

Financial Markets and Institutions 8

Chapter 2
 Present Value
Present value tells us how much an
expected future payment is worth today.
Alternatively, it tells us how much we
should be willing to pay today to receive
some amount in the future.
For example, if the present value of $1.10 at
an interest rate of 10% is $1, we should be
willing to spend $1 today to get $1.10 next
year.

Financial Markets and Institutions 9

Chapter 2
 Present Value Formula
There is a general relationship between present
value and future value that tells us the present
discounted value of future payment received at
a certain time.

The formula for present value can be found by

rearranging the compounding formula.
FV = PV(1 + i)
FV/(1 + i) = PV

Financial Markets and Institutions 10

Chapter 2
 Present Value Example
Suppose we buy a bond that pays $10
every year for three years and then repays
the $100 principal. What is the present
value of this bond?
$10/(1.10) + $10/(1.10)2 + $110/(1.10)3 =
= $9.09 + $8.26 + $82.64 = $100

Financial Markets and Institutions 11

Chapter 2
 Things to Notice
An increase in the interest rate causes
present value to fall.
Higher rates of interest mean smaller amounts
can grow to equal some fixed amount during a
specified period of time.
A decrease in the interest rate causes
present value to rise.
Lower rates of interest mean larger amounts
are needed to reach some fixed amount
during a specified period of time.
Financial Markets and Institutions 12
Chapter 2
 Examples
How much must I invest today to get $10,000 in five years
if interest rates are 10%?
PV = FV/(1 + i)n
PV = $10,000/(1 +0.10)5 = $10,000/1.6105 = $6,209.2

How much must I invest today to get $10,000 in five years

if interest rates are 5%?

PV = FV/(1 + i)n
PV = $10,000/(1 + .05)5 = $10,000/1.2763 = $7,835.15

Financial Markets and Institutions 13

Chapter 2
 Time Value of Money
The longer the time to maturity, the less
we need to set aside today.
This is the principal lesson of present
value. It is often referred to as the time
value of money.

Financial Markets and Institutions 14

Chapter 2
 Example:
If I want to receive $10,000 in 5 years, how much do I
have to invest now if interest rates are 10%?

$10,000 = PV*(1 + 0.10)5

$10,000/1.5105 = $6209.25

If I want to receive $10,000 in 20 years, how much do I

have to invest now if interest rates are 10%?

$10,000 = PV*(1 + 0.10)20

$10,000/6.7275= $1486.44

Financial Markets and Institutions 15

Chapter 2
 Types of Credit Instruments
There are four types of credit instruments:
the simple loan
the fixed payment loan
coupon bonds
discount bonds

Financial Markets and Institutions 16

Chapter 2
 Types of Credit Instruments
Simple Loan Contracts:
The borrower (contract issuer) receives from
the lender (contract holder) a specified
amount of funds (the principal) for a specified
period of time (the maturity).

The borrower agrees that, at the end of this

period of time -- referred to as the maturity
date -- the borrower will repay the principal to
the lender together with an additional
payment referred to as the interest payment.

Financial Markets and Institutions 17

Chapter 2
 Simple Loan Contracts
Borrower
receives

Principal
MATURITY DATE
START

Principal +
Interest payment

Lender
receives
Financial Markets and Institutions 18
Chapter 2
 Simple Loan Contracts
A borrower receives a loan on January 1,
1999, in amount $500.00, and agrees to pay
the lender $550.00 on January 1, 2001.
Principal is $500.00, the maturity is 2 years
Interest payment is $50.00.
The simple (annual) interest rate for this loan
is then $50/[$500*2] = 0.05, or 5%.
In this case $500 is PV of $550 in 2 years

Financial Markets and Institutions 19

Chapter 2
 Types of Credit Instruments
Fixed-Payment Loan Contracts:
The borrower (contract issuer) receives
from the lender (contract holder) a specified
amount of funds -- the loan value -- and, in
return, makes periodic fixed payments to
the lender until a specified maturity date.

These periodic fixed payments include both

principal (loan value) and interest (there is
no lump sum repayment of principal)

Financial Markets and Institutions 20

Chapter 2
 Fixed-Payment Loan Contracts
Borrower
receives

Loan value
MATURITY DATE
START

Lender Fixed Fixed Fixed

receives payment payment payment

Financial Markets and Institutions 21

Chapter 2
 Fixed-Payment Loan Contracts
There is 15-year installment loan with a
finance company to pay for a new car.
Under the terms of this loan, $20,000 now to
finance the purchase of a new car
Payment of $2000 every year for the next 15
years to the finance company.
The simple (annual) interest rate for this loan
is then $10000/[$20000*15] = 0.03, or 3%.

Financial Markets and Institutions 22

Chapter 2
 Coupon Bond
Under the terms of coupon bond, the borrower
(bond issuer) agrees to pay the lender (bond
purchaser) a fixed amount of funds (the coupon
payment) on periodic basis until a specified
maturity date, at which time the borrower must
also pay the lender the face value (or "par
value") of the bond.
The coupon rate of coupon bond is the amount
of the coupon payment divided by the face value
of the bond.

Financial Markets and Institutions 23

Chapter 2
 Coupon Bond
Borrower
receives

Purchase price
MATURITY DATE
START

Lender Coupon Coupon Coupon

receives payment payment Payment +
Face value

Financial Markets and Institutions 24

Chapter 2
 Example of a Coupon Bond
Suppose a coupon bond has a face value of
$1000, a maturity of five years, and an annual
coupon payment of $60.
Then, at the end of each year for the next five
years, the borrower (bond issuer) must pay the
lender (bond holder) a coupon payment of $60.
In addition, at the end of five years (the maturity
date), the borrower must pay the lender the face
value of the bond, $1000.
The coupon rate for this coupon bond is
$60/$1000 = 0.06, or 6 percent.
Financial Markets and Institutions 25
Chapter 2
 Coupon Bond
PVB = C/(1 + i) + C/(1 + i)2 + C/(1 + i)3 +
..C/(1 + i)n + P/(1 + i)n
where
C is a fixed coupon
i is the rate of interest
PB is the price or present value of the bond
P is the principal
n is years to maturity
When a coupon bond is priced at its face value,
the yield to maturity equals the coupon rate.
Financial Markets and Institutions 26
Chapter 2
 Yield to Maturity
Yield to maturity is the interest rate that
equates the present value of payments
received from a debt instrument with its value
today.
Tells us what the yield on a current
investment is if we hold it until maturity
Yield to maturity can be calculated using the
present value formula.
PV = FV/(1 + i)
i = (FV PV)/PV
Financial Markets and Institutions 27
Chapter 2
 YTM for Simple Loans
What is the yield to maturity on a $100
loan that repays the lender $110 next
year?
$100 = $110/(1 + i)
i = ($110 - $100) / $100 = $10 / $100 =
0.10= 10%

Financial Markets and Institutions 28

Chapter 2
 YTM for Fixed-Payment Loans
What is the yield to maturity on a $1000 loan
that repays the lender $126 per year for 25
years?
By using fin calculator or Excel we could find
YTM RATE(25;-126;1000;0;0) =12%

Financial Markets and Institutions 29

Chapter 2
 YTM for Discount Bonds
A discount bond is one that is sold at a
discount from its face value
Yield formula:
i = (Face Value - Price Paid)/Price Paid
What is the YTM of a one-year discount
bond with a current price of $900 and a
face value of $1000?
$900 = $1000 / (1 + i)
i = ($1000 - $900) / $900 = 0.111= 11.1%
Financial Markets and Institutions 30
Chapter 2
Bond Price and Yield to Maturity
YTMs on a 10% Coupon Rate Bond Maturing in
Ten Years with Face Value of $1000
How are price and yield to maturity related?

Financial Markets and Institutions 31

Chapter 2
Price, YTM, and the Coupon Rate
Four interesting facts:
Price and yield are negatively related.
When price is above par, the yield to maturity
is less than the coupon rate.
When price is at par, the yield to maturity
equals the coupon rate.
When price is below par, the yield to maturity
is greater than the coupon rate

Financial Markets and Institutions 32

Chapter 2
 Current Yield
There are also simple formulas that can
approximate yield to maturity such as current
yield
Current yield is an approximation for yield to
maturity that is used to calculate the interest
rate on a bond quickly.
Formula: Current yield = Coupon/Bond Price
A change in current yield always signals a
change in the same direction as yield to
maturity.

Financial Markets and Institutions 33

Chapter 2
 Example
Assume you buy a $1,000 bond today with
a fixed coupon of $100. You are receiving
a 10% return.
Let a year pass, and you find you want to
sell you bond. You call your broker and
say, Sell!
Your broker sighs and tells you that bonds
just like yours now yield 12%. What price
can you expect to receive?
Financial Markets and Institutions 34
Chapter 2
 Example
Use the current yield formula:
0.12 = $100/PB
0.12PB = $100
PB = $100/.12 = $833.33

Financial Markets and Institutions 35

Chapter 2
 Even More Things to Notice
The price of a coupon bond and the yield
to maturity are inversely related.
An increase in the interest rate decreases the
bond price.
A decrease in the interest rate increases the
bond price.
This is the reason the market participants
are so interested in the actions of the
Federal Reserve.
Financial Markets and Institutions 36
Chapter 2
 Interest Rates and Returns
The return to a bond depends on its stream of
coupon payments and the price the bond
receives when it is sold.
If the bond sells at a price in excess of its
original purchase price, the owner receives a
capital gain which increases his/her total return.
If the bond sells at a price below its original
purchase price, the owner suffers a capital loss,
which decreases his/her total return.

Financial Markets and Institutions 37

Chapter 2
 Return on a Bond
Suppose you hold a coupon bond today (i.e. time
t) that you plan to sell one year from today. Its
rate of return would consist of two components

Financial Markets and Institutions 38

Chapter 2
 Return on a Bond
The only bond whose return is certain to
equal the initial yield is the one whose time
to maturity is the same as the holding
period.
A rise in interest rates is associated with a
fall in bond prices, resulting in capital
losses on bonds whose terms to maturity
are longer than the holding period.

Financial Markets and Institutions 39

Chapter 2
 Return on a Bond
The longer the bonds maturity, the greater
is the size of the price change associated
with an interest rate change.
The longer a bonds maturity, the lower is
the rate of return that occurs as a result of
the increase in the interest rate.
Even though the bond had a good interest
rate, its return became negative when
interest rates rose.
Financial Markets and Institutions 40
Chapter 2
 Reinvestment Risk
Reinvestment risk occurs
when an investor holds a series of short
bonds over a long holding period and interest
rates are uncertain.
If interest rates rise, the investor gains
If interest rates fall, the investor loses

Financial Markets and Institutions 41

Chapter 2
 Reinvestment Risk: Example
Assume a holding period of two years and
an investor who has decided to buy two
one year bonds sequentially.
Year 1 bond:
Face = $1000, initial interest rate = 10%
At the end of the year, the investor has $1100.
Year 2 bond:
Face = $1100, interest rate = 20%
At the end of year 2, the investor has $1320.

Financial Markets and Institutions 42

Chapter 2
 Reinvestment Risk: Example
The investors two year return will be:
($1320 - $1000)/$1000 = 0.32 = 32% over two
years.
In this case the investor has benefited by
buying two one year bonds.
Conversely, if interest rates had fallen to 5%,
the investor would done less well.

Financial Markets and Institutions 43

Chapter 2
 Reinvestment Risk: Example
Year 1:
($1000 x (1 + 0.10)) = $1100
Year 2:
($1100 x (1 + 0.05)) = $1155
Return = ($1155 - $1000)/$1000 = 15.5%
over two years.
The investor now loses from a change in
interest rates.

Financial Markets and Institutions 44

Chapter 2
 Real and Nominal Interest
Rates
Nominal interest rate is the rate of interest
that makes no allowance for inflation.
The real interest rate is the rate of interest
that is adjusted for expected changes in
the price level.
It more accurately reflects the true cost of
borrowing and lending.

Financial Markets and Institutions 45

Chapter 2
 Fisher Equation
The Fisher equation states that the nominal
interest rate equals the real interest rate
plus the expected rate of inflation
in = i r + p
Rearranging terms we find:
ir = i n - p

Financial Markets and Institutions 46

Chapter 2
 Logic behind the Inflation
Premium
Lenders want to be compensated for the
loss in buying power due to inflation.
Buyers understand that they will be
repaying debt with dollars that buy less.
The interest rate must reflect these facts.

Financial Markets and Institutions 47

Chapter 2
Economic Forces Affected Interest
Rates
Economic Growth
Inflation
Money Supply
Budget Deficit
Foreign Flows of Funds

Financial Markets and Institutions 48

Chapter 2
 Economic Forces Affected Interest
Rates
Inflation
If inflation is expected to increase
Households may reduce their savings to make
purchases before prices rise
Also, households and businesses may borrow more to
purchase goods before prices increase
The Fisher Effect
Nominal rates compensate investors two ways:
compensate for reduced purchasing power
compensate for foregoing current consumption
in = ir + p
Financial Markets and Institutions 49
Chapter 2
 Economic Forces Affected Interest
Rates
Money Supply
When the Fed increases the money supply, it
increases supply of loanable funds
Places downward pressure on interest rates
Budget Deficit
Increase in deficit increases the quantity of
loanable funds demanded

Financial Markets and Institutions 50

Chapter 2
 Economic Forces That Affect
Interest Rates
Foreign Flows
In recent years there has been massive flows
between countries
Driven by large institutional investors seeking
high returns
They invest where interest rates are high and
currencies are not expected to weaken
These flows affect the supply of funds available
in each country

Financial Markets and Institutions 51

Chapter 2
Origin of the Federal Reserve System
1913 Federal Reserve Act
Goal to solve problems of bank panics
Set up the structure of the Fed
12 district banks, initially decentralized
Reserve requirements for member banks

Financial Markets and Institutions 52

Chapter 2
Structure of the Federal Reserve
12 Federal Reserve district banks (Boston, New
York, Philadelphia, Atlanta, Cleveland, Chicago,
Dallas, Minneapolis, Kansas City, San
Francisco, St. Louis, and Richmond)
The three largest Fed Banks in terms of assets
are New York, Chicago, and San Francisco.
Member banks, private commercial banks
Board of Seven Governors
Federal Open Market Committee or FOMC
Advisory committees

Financial Markets and Institutions 53

Chapter 2
Organization of the Federal Reserve
Board of Governors
Seven individuals appointed by the
U.S.president and confirmed by the Senate
U.S. president appoints one of the seven
chair whose 4-year term is renewable
Offices in Washington D.C.
Serve nonrenewable 14-year term

Financial Markets and Institutions 54

Chapter 2
 Board of Governors
(7 appointed members)
Control monetary policy:
reserve requirements
Discount rate
Supervise and regulate
member banks
and bank holding companies
Oversight of 12 Fed district banks
Consultation
Consumer advisory
Council
Federal advisory
Council
Thrifts Institutions Make monetary policy decisions to achieve goals
Advisory Council
Financial Markets and Institutions
District Banks (12)
Propose the level of discount rate
Overall
Keep the reserves of depository
supervision
Institutions and extent the loans
Clear check, replace old currency,
make discount loans, collect and
analyze data regarding economic
Situation in their districts
Public debt management
Execution of unified management
Federal Open Market Committee (FOMC)
12 members (7 from the Board of Governors,
President of the NY Fed and
4 other district bank presidents
Open market operations are the purchase
or sale of government securities
55
Chapter 2
 Monetary Policy Tools
Tools to decrease or increase the money
supply
Reserve requirements
Open market operations
The discount rate

Financial Markets and Institutions 56

Chapter 2
How the Fed Controls Money Supply
Banks must maintain reserves as % of
deposits
Reserves kept as deposits in Fed
Fed controls level of member bank reserve
deposits in fed
Fed influences bank deposit portion of money
supply

Financial Markets and Institutions 57

Chapter 2
Action Interim result Final result
Increase in Increase of Increase of
reserves Depositary Money supply
institutions
Net surplus assets
of reserves

(a) Increase of Growth of

Reduce of investments Bonds price
reserve
requirements
Drop of
Interest rates

(b) Increase of
Loans volume More funds
available
to loans
Financial Markets and Institutions 58
Chapter 2
 Monetary Policy Tools
Open market operations are the purchase or
sale of government securities based on
FOMC directives sent to NY Fed Trading
Desk
Open market involving the purchase of
government securities
Purchase securities from government
securities dealers
Increases the money supply

Financial Markets and Institutions 59

Chapter 2
 Monetary Policy Tools
Open market operations and interest rates
Most rates are market determined but Fed
influences
Fed purchase of securities results in an
injection of additional funds into the bank
system
More funds available for commercial banks to
loan to customers
Rates drop

Financial Markets and Institutions 60

Chapter 2
 Monetary Policy Tools
Adjusting the discount rate
Discount window at the Fed lends to
depository institutions
Adjustment credit for short-term liquidity
problems
Seasonal credit
Extended credit for longer liquidity problems
Lower rate, money supply increases

Financial Markets and Institutions 61

Chapter 2
Action Interim result Final result
Increase of Increase of
Reduce of Increase of
Depositary Depositary
discount rate Money supply
institutions institutions
reserves assets

(a) Increase of Growth of

Loans volume Bonds price

(b) Increase of
investments
Reduce of rate Drop of
on FRF Interest rates

The market is
steady

Financial Markets and Institutions 62

Chapter 2